Until Further Notice, Strong Should Be Avoided

<P>The latest news out of Menomonee Falls, Wis., is too much to ignore.
<P>Investors have read with great concern numerous articles in the finacial press relating to what could be the biggest scandal in the history of the mutual fund industry: Last week, New York State Attorney General Eliot Spitzer filed a <A href="http://www.oag.state.ny.us/press/2003/sep/canary_complaint.pdf" target="_blank" >complaint</A> alleging that four prominent fund firms, including Strong, had agreed to grant special trading access to a hedge fund, arguably ripping off fund investors in the process. As we have written, the event may result in several regulatory changes and will surely cause fund investors to question the industry's character.
<P>The complaint offered relatively few details on the particulars of Strong's involvement, and the firm's only response says that it is cooperating with the Attorney General's office and conducting an internal review. But what was included in Spitzer's report is potentially damaging. The attorney general obtained documents suggesting that Strong agreed to give Canary Capital permission to buy and quickly sell five mutual funds--Strong Growth <?XML:NAMESPACE PREFIX = MSTR /?><MSTR:SECURITY>SGROX</MSTR:SECURITY>, Strong Large Cap Growth <MSTR:SECURITY>STRFX</MSTR:SECURITY>, Strong Growth 20 <MSTR:SECURITY>SGRTX</MSTR:SECURITY>, Strong Dividend Income <MSTR:SECURITY>SDVIX</MSTR:SECURITY>, and Strong Advisor Mid Cap Growth <MSTR:SECURITY>SMDCX</MSTR:SECURITY>.
<P>One of the worst things about the news is that reading the fund's prospectuses leaves investors with the impression that the firm doesn't allow this practice. Another is that Strong allegedly instructed its transfer agent and clearing broker to ignore the typically unacceptable trades.
<P>We think investors should add this development to the list of reasons to avoid Strong funds. First, performance at the shop has been mediocre, particularly on the equity front. Of the 20 largest offerings in Strong's stock-fund lineup--which includes funds that range from $3 billion to $90 million in assets--two own star ratings of 4 stars, 11 have earn 3 stars, and seven have achieved 2 stars. This example suggests few outstanding performers, and many that have turned in mediocre showings over the years. It also excludes funds that are no longer among the living: At least one of these offerings, 2-star Strong Multi-Cap Value <MSTR:SECURITY>SMTVX</MSTR:SECURITY> is headed for the merger heap where it will join other undistinguished and now-defunct offerings such as Strong Internet and Strong Balanced Asset.
<P>The company has also failed to keep the costs of many of these funds in check. The bear market was rough on growth funds, and Strong's lot of aggressive funds wasn't spared. Investment losses cut into asset bases, and expenses climbed. While that's to be expected in some cases, a few Strong funds have seen their expense ratios leap in recent years.
<P>Most notably, from 2000 to 2002, Strong Growth 20's expenses soared from 1.3% to 1.9%; Strong Blue Chip Growth's <MSTR:SECURITY>SBCHX</MSTR:SECURITY> jumped from 1.1% to 1.6%; and Strong Enterprise's <MSTR:SECURITY>SENTX</MSTR:SECURITY> rose from 1.4% to 2%. Looking again at the 20 largest funds, 12 have expense ratios of 1.5% or more. These costs eat into returns, which as mentioned above aren't so hot in the first place.
<P>Also, the firm has had to deal with a fair number of manager changes. Prominent bond bosses Jeff Koch, Brad Tank, and Jonathan Bender left the firm in what seemed like one fell swoop in mid-2002. Ron Ognar, a respected manager in the aggressive-growth world, stepped aside in June. As if the losses to a number of Strong's largest funds weren't enough, the company kept the same aggressive strategy in place at each fund, despite the fact that the architect of each process had left with his T-square.
<P>In all, taking a look at the 29 Analyst Reports that Morningstar had penned on Strong's funds before the Spitzer allegations came to light, we had somewhat favorable opinions on only eight of them. That's a very low batting average (.276) for a whole fund shop.
<P>With $42 billion in assets under management, privately-held Strong is the smallest of the firms involved in the Spitzer investigation so far, and money management is its bread-and-butter business. Its tiny size relative to industry giants Fidelity and Vanguard has undeniably informed its business moves over the years.
<P>For example, the family has been quick to launch new funds meant to capitalize on narrow trends such as Strong Dow 30 Value <MSTR:SECURITY>SDOWX</MSTR:SECURITY> in 1997, the now-defunct Internet Fund in late 1999, and a host of value funds during the bear market. It also added its name to the list of shops that has added sales loads to several of its funds in late 2000.
<P>These efforts to boost assets have met with mostly unencouraging results. None of the faddish funds has garnered more than $200 million in assets, and the load endeavor, while it has led to inflows, hasn't come close to placing Strong near the top of financial advisors' favored-fund list.
<P>The picture presented above raises questions about where fund shareholders rank in Strong's priorities. This latest asset-grabbing move--to gain perhaps as little as $18 million in assets according to Spitzer's findings--adds insult to injury. It's rare that we recommend that fund investors avoid an entire firm, especially one of Strong's size; it's the equivalent of earning an F letter grade. But given the severity of the charges, we see no reason for investors to hang around.</P>
<P><EM>Paul Herbert is an analyst with Morningstar.</EM></P>